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0.8.5: Preferred Stock
Preferred stock comes in various shapes and sizes, depending on the intent and desires of the planners. Assuming it is so authorized in the charter, the board of directors may fix the rights, preferences, and privileges of the preferred, a practice creating what is known as "blank-check preferred." There are virtually no limits on the board's authority to frame a mosaic of rights and call the same a "preferred" stock. Some of the reasons to prefer (pardon the pun) preferred stock as a financing device have been discussed elsewhere in the text—that is, the "eat- 'em-up" preferred, which makes possible price differentials between prices paid for stock by the investors and the founders. An overriding reason is convenience: although it is possible to work with other devices, it is particularly handy to use preferred stock as a mechanism to adjust the relationship between the cash and non-cash investors; that is, to create specific rights in the cash investors such as special voting rights, antidilution protections, control shifts, "supermajority" veto provisions, and the like. A preferred stock can either be voting, nonvoting, or voting only upon certain issues, or upon the happening of certain events. In the case of the convertible preferred customarily issued in a venture financing, it is the norm to provide that the preferred votes pari passu with the common as if it has been converted. Beyond the preferred dividend, preferred stock in the instant context is usually "nonparticipating," meaning that earnings over and above the dividend are available to the common shareholders; the preferred holders' access to those earnings is postponed until conversion.
The traditional notion of preferred stock encompasses a share that takes its "par" value in liquidation before the common gets anything (a meaningful privilege if the company is being sold) and has a preferred call on the earnings of the corporation during its life in the form of a regular dividend. A "preferred" dividend implies a fixed dividend payable at regular intervals; if the dividend is not declared for any reason (perhaps illegality, if and to the extent sufficient earnings or surplus are not available), it "cumulates," meaning arrearages must be paid in the future before any dividend or liquidating distribution can be paid on inferior classes of stock, such as common. (Unlike interest, cumulative dividends are usually not augmented by an incremental additional payment keyed to the period during which they remain unpaid—interest on interest.) If cumulative dividends are passed for several periods, it is often (but not necessarily) provided that a "default" occurs and something automatically happens, usually in the form of the preferred shareholders getting additional seats on the board. "Participating" preferred (see below) is preferred that may or may not enjoy a fixed dividend, but in any event participates in excess earnings pari passu (or on some other formula) with the common shareholders.
Cumulative dividends expressed in cash terms are not common in start-ups. The idea of paying cash dividends at all makes no sense to some entrepreneurs (e.g., Kenneth Olson while at Digital Equipment) , because the transaction is ultimately dilutive if and as the issuer, in effect, retrieves the capital paid out in dividends by issuing more stock. More importantly, immature companies often do not have the cash with which to pay dividends. Noncumulative dividends, meaning dividends paid only if, as, and when declared by the board, are the venture-capital norm. Indeed, the disclosure document in a preferred-stock venture financing often contains a caveat to the effect that the dividends are not only noncumulative, it is "unlikely" the directors will declare them at all. A start-up may, however, distribute future calls on earnings by providing for regular or irregular dividends on the preferred payable in stock, either preferred or common. This is one method of adjusting equity percentages based on performance of the company; if the founders have been missing targets, the board may be able to compensate the investors by voting the preferred some additional stock. These are, of course, traps for the unwary. Thus, preferred stock received as a dividend—the classic "preferred-stock bailout" or earnings—may become "Section 306 stock", which, when sold, turns capital gain into ordinary income. Moreover, §§305(b) and (c) of the Internal Revenue Code can create taxable events when a corporation distributes stock to its stockholders in a disproportionate way. Moreover, it is not clear that holders of preferred stock enjoy the same fiduciary protection as common shareholders.
The preferred's liquidation preference is not normally the occasion for much discussion in a startup or buyout financing because none of the interested parties believe that distributions in liquidation of a venture-backed startup or LBO will extend beyond the secured and unsecured creditors. On occasion, however, venture-backed companies may liquidate with proceeds available beyond the creditors' claims. Indeed, in insolvency proceedings involving substantial assets, something is usually thrown to the stockholders even though the creditors get less than 100¢ on the dollar. (The plan gives lip service to the "rule of absolute priority" in bankruptcy by giving the creditors cash plus securities "valued" at 100¢, leaving something left over with which to bribe the shareholders not to fight.) In such instances, the preferred liquidation preference may be significant. The preference also becomes significant if the issuer is merged into another company. The founder may argue that the preferred should be required to convert or be automatically converted prior to the merger—the merger is an "exit" vehicle. The investors, on the other hand, will argue that a sale of the company yielding an attractive price to the common stockholders will cause them voluntarily to convert; they are entitled to protection, on the other hand, if the proceeds are so meager that they do not cover the liquidation preference.
Automatic conversion on the eve of an IPO is usually less controversial. Indeed, it is often necessary to clean up the balance sheet and cancel various special rights peculiar to separate classes of stock if an IPO is to occur at all; those counsel who have survived a multiparty negotiation in which the holders (perhaps including former employees who simply detest the company) must be cajoled into converting can testify to the value of automatic conversion.
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